Even the most heinous of financial crimes are usually – if not always – the bi-product of willing participants. Admittedly, there may be only one “evil genius” in the mold of Bernie Madoff, but invariably there are many willing enablers. These are the peripheral players to whom we might contribute some degree of culpability or at least benign neglect: Never asking the tough questions; uncritically following the crowd; accepting rewards for silence and moral passivity; and, putting introspection on auto-pilot. ~PCQ
Background. Before we get to “The Comeuppance,” we need to address what might be moralistically described as “The Pride before the Fall.”
Certainly, the boom and bust of the credit and housing markets of 2005-2007, can be attributed to many factors; there were multiple players and participants. For example:
- There was pressure by the federal government to extend the dream of homeownership to persons who deserved it, but could not afford it;
- There was Wall Street’s securitization machine that encouraged the mass marketing of mortgages;
- Fannie and Freddie, heretofore wildly successful quasi-public corporations that seemingly served the secondary mortgage market well, both played a role in their own demise;
- There was the big investment banks’ creation of a Private Label secondary market, thus enabling home loans to be given to borrowers that Fannie and Freddie wouldn’t touch;
- Added to this were the financial and real estate industries, which convinced themselves that property appreciation was like a perpetual motion machine, and would continue forever;
- And then there was the American Public, whose insatiable appetite for homeownership turned them into lemmings, following one another over a financial cliff.
So Riddle Me This Batman: Could any of these players, individually or collectively, have caused both the boom and bust of the financial and housing markets? No. In short, none of the above players or participants between 2005 and 2007 could have single-handedly enabled the boom and bust. The bomb needed some plutonium. Enter the ratings agencies….
The Ratings Agencies. The ratings agencies have been ranking the quality of U.S. securities for a hundred years. The source of their outsized power comes from the SEC which gave them the status of a “nationally recognized statistical rating organization” or “ NRSRO” in 1975. The big three, Fitch, Moody’s and Standard & Poor’s were grandfathered in. According to the SEC, there are ten ratings agencies in the country today. And according to David Reiss, Assistant Professor, Brooklyn Law School (Subprime Standardization: How Rating Agencies Allow Predatory Lending to Flourish in the Secondary Mortgage Market, 2007):
“…the ratings agencies enjoy a “privileged regulatory status” that is granted by various government bodies in exchange for the quasi-public responsibilities…by providing ratings to the investment community but is not paired with any commensurate monitoring of the privileged raters themselves. Thus, the privileged raters themselves are privileged because regulators have incorporated the service (ratings) that they sell into the regulatory structure of the capital markets. In addition, the investment-grade ratings that the privileged raters issue are themselves equivalent to a “regulatory license” that confers a significant financial benefit on its recipient.”
Essentially, the ratings agencies became the de facto validator of investment securities. In order for Wall Street’s Private Label secondary market to attract investors, it needed investment quality ratings. So the two entered into a Faustian pact: The agencies would teach the big investment banks [for a fee] how to package and pool their toxic tranches so that the ratings agencies [for another fee] could give them investment grade ratings and investors would thereby purchase them in reliance on the agencies’ historic imprimatur.
So it was that the big ratings agencies, acting as Wall Street’s shills, were able to single-handedly turn straw into gold – or more precisely, turn junk into investment grade bonds. While the investment banks were the architects, ratings were the sine qua non. Nothing would have been possible had not the ratings agencies willingly participated. As a result, between 2005 and 2007, investors flocked to the securities marketplace, believing in the accuracy of the ratings given to these toxic tranches. Thereby, Wall Street was able to foist onto the American public billions of dollars of poorly underwritten loans that, for all intents and purposes, were DOA the day they closed. In July 2007, when Moody’s and S&P finally owned up to what they had known for years, they reversed themselves; the straw really was just straw. It was The Day The Music Died.
In Wall Street and the Financial Crisis: Anatomy of a Financial Collapse, April 13, 2011, pp. 45-46 [hereinafter, the Levin Report.”], the Congressional staff concluded that:
“…the most immediate trigger to the financial crisis was the July 2007 decision by Moody’s and S&P to downgrade hundreds of RMBS and CDOs. The firms took this action because, in the words of one S&P senior analyst, the investment grade ratings could not “hold.” By acknowledging that RMBS and CDO securities containing high risk, poor quality mortgages were not safe investments and were going to incur losses, the credit rating agencies admitted the emperor had no clothes. Investors stopped buying, the value of the RMBS and CDO securities fell, and financial institutions around the world were suddenly left with unmarketable securities whose value was plummeting. The financial crisis was on.” [Underscore mine. PCQ]
A graphic reminder of the effect of the July ratings downgrades is the historic RMLS™ statistics going back to that time. In August, 2007, the average sale price of a home for the Portland Metro area was $355,000. Prices have retreated from that point steadily to the present time. They never went any higher, and have fallen ever since. [However, the May, 2012 RMLS™ numbers do give a glimmer of hope that we may be rounding the corner.]
When the downgrades occurred, the tremor largely escaped detection by the American public. However, it was well known on Wall Street and likely at the highest levels of government, e.g. by then-Secretary of Treasury, Henry Paulson. But it never was picked up by the mainstream press, which, in 2007, was likely more interested in the goings on of Paris Hilton.
The Downgrades. According to the Levin Report, here were the successive ratings downgrades:
- Beginning in July of 2007, Moody’s and S&P made mass downgrades of hundreds of subprime residential mortgage-backed securities or “RMBS.” These were the huge pools of securities that consisted of millions of residential loans that Wall Street had been packaging and selling to investors since 2005. It was the beginning of the end.
- An aftershock occurred in October of 2007 with mass downgrades by Moody’s of collateralized debt obligations or “CDOs.”
- In December 2007, Moody’s downgraded another $14 billion in CDOs, and placed another $105 billion on credit watch.
- In a single day, January 30, 2008, S&P took action on over 6,300 subprime RMBS securities and over 1,900 CDO securities. The affected RMBS and CDO securities “represented issuance amounts of approximately $270.1 billion and $263.9 billion, respectively.”
According to the Levin Report:
“Analysts have determined that, by 2010, over 90% of subprime RMBS securities issued in 2006 and 2007 and originally rated AAA had been downgraded to junk status by Moody’s and S&P.” [p.267]
The Report adds:
“Neither Moody’s nor S&P produced any meaningful contemporaneous documentation explaining their decisions to issue mass downgrades in July 2007, disclosing how the mass downgrades by the two companies happened to occur two days apart, or analyzing the possible impact of their actions on the financial markets.” [p. 265.]
But one thing is known for sure: The default risk of subprime mortgages was not unknown to the ratings agencies. According to the Levin Report:
“The evidence shows that analysts within Moody’s and S&P were aware of the increasing risks in the mortgage market in the years leading up to the financial crisis, including higher risk mortgage products, increasingly lax lending standards, poor quality loans, unsustainable housing prices, and increasing mortgage fraud. Yet for years, neither credit rating agency heeded warnings – even their own – about the need to adjust their processes to accurately reflect the increasing credit risk. Moody’s and S&P began issuing public warnings about problems in the mortgage market as early as 2003, yet continued to issue inflated ratings for RMBS and CDO securities before abruptly reversing course in July 2007.” [Emphasis added.]
Conclusion. It was a classic “Bait and Switch.” Once thousands of securities that had been rated as “investment grade” and sold to investors, they were downgraded to junk. The result was that large public and private investors and retirement funds were required by their regulatory rules to divest them. When that happened, sufficient funding was no longer available to feed the securitization beast, aka “Wall Street.” Without investors buying these toxic brews, credit tightened up almost immediately. When that occurred, people could no longer borrow money to purchase homes – and homeowners could no longer sell. Borrowers who bit off more than they could chew, could not, by re-selling or refinancing, extricate themselves from their bad decisions. The result was that home prices collapsed – so much so that values often fell far below their loan amounts. With the gravity of short sales, foreclosures, and REO prices tugging ever downward, this country experienced the worst financial and housing collapse since the Great Depression.
[Part Two: “The Comeuppance.”]